It has become super easy to form a corporation. I can do it in about 15 minutes. As such, many, many corporations are being formed, especially amongst the technically literate. They are so common, most people treat an LLC or Corporation as an extension of themselves – an alter ego. Many people don’t realize they are not buying themselves what they think they are when they click that checkout button on the Secretary of State’s website. I discuss in a later post how and why you should rethink formation, but here I’ll focus on what you need to do to stay above board after the fact.
Now to be sure, it is a very, very rare occurrence to see the protection of a corporation, the corporate veil, be pierced but I have personally seen it done successfully. 95% of all vanity corporate registrations are never going to concern themselves with it, so long as you’re not running some kind of sham. But then you have to stop and wonder why you formed the organization to begin with.
The number 1 reason to form a legal organization to do business is to get protection so you don’t lose your house if your business fails. Sharing ownership is a secondary reason for formation, although partnerships form all the time without business registration. Obscuring ownership, and representation as a business are other reasons, although these can be done without forming a legal organization. Unfortunately, establishing the corporate identity is only one of many things that must be done to actually enjoy protection of a legal organization. Unless that operation is run correctly, protection can be eliminated and your house and retirement savings are suddenly put at risk if there is a lawsuit or attempt to collect any indebtedness.
The decision for a court to “pierce the corporate veil” or bypass the protections that are in place so you aren’t risking it all depends on a list of factors. Mostly, they are concerned with whether the organization is an alter ego of the organization’s “owner”. While no one thing will be enough for them to go after you personally, if you fall short in a couple of ways you may lose. Adherence to all of them, or even most of them, will be sure to protect you.
The first thing I see people doing that is a huge mistake is casually funding or supporting their organization or worse, taking money out of the organization. The number one boundary the organization needs is financial. If you pass money back and forth much then your organization is at risk of being viewed as a sham or a front, even if you do have a legitimate business and legitimate reasons for passing money.
To this day I am baffled that the startup FTX and it’s partner Alameda Research had such poor money controls. It is abundantly clear that they didn’t follow this advice and bankruptcy receivers are digging and struggling to figure out the tangled web of money. Not only are there criminal indictments related to that bad money trail, it seems likely at this point that money will be clawed back from anyone who received any kind of return on their investment in the organization (but not deposit… the difference matters here). Don’t be FTX. Keep it separate.
You are far better off executing a loan document to your organization if it needs a leg up in funding. Loan documents can be short and sweet, but need to be approved by either the board for a Corporation or the members for an LLC. Then when you subsequently pull that money back out, it can simply be written off as a repayment on that loan. The key issue is you have a good reason and documentation for the transfer and maintain the funding for the organization as a separate island.
If you have more than one organization, you need more than one independent pool of money. One mistake I have seen consecutive, merging or serial entrepreneurs do is use money from one pool to fund the other business. This was one of the squirrely things they did between FTX and Alameda Research. Because ownership rights are unique to each organization, the money needs to be independently accounted for.
This gets into hairy business for employees (or founders!) who may work for both. Figure out what percent of their time they spend doing work for each and that should be a contracted transfer from the accounts. One organization or the other is going to need to “own” the employee (and do payroll taxes, benefits, etc.) so they can be contracted to the other organization. It can all be done on the books so it feels seamless to everyone. Contracting services and space can be another way to legitimately transfer money, but be sure to get (disinterested) board agreement on the substance of those contracts, so you can show that you are not just self-dealing. Alternately, you can have employees who are employed by both. This works better for founders, but is still likely to get you into wage and hour issues with the state.
Getting board or member agreement for all your money arrangements is important. Holding (or “holding”) regular, documented meetings are non-optional. A corporation requires at minimum a board meeting and a shareholder meeting every year. An LLC just needs a member meeting. You also need to have formal decisions for the sale or buyback of stock, changes to your articles or bylaws, or any other important decision like dividends.
You don’t need to have actual meetings to create this paper trail. Unanimous consent is always the easiest way to go for really small organizations and it’s usually available, but just like the money, you need a paper trail to show that you got it. Even “disinterested board member” will fly if you can get unanimous consent since this process requires consent of all board members. With documented consent, you can end run the notice periods, not to mention skip pointless meetings where everyone agrees anyway.
But you need to keep those minutes! I strongly recommend having a 3-ring binder to keep a record, as well as a (backed up) file folder on your computer. Be aware: minutes are not meeting notes! The minimum minutes need to include is all the items up for decision and what the board decided. Discussions do not need to be recorded. Who voted for or against should be recorded, but why they voted the way they did only clutters things up. Similar records should be kept for member meetings for an LLC.
Stockholder meetings for a corporation are primarily to elect directors every year. They can take on other responsibilities as decided by the board in the bylaws, but most don’t. All voting can be done “by proxy” so you can have an “on paper” meeting for that too.
Other factors as to whether an organization is an alter ego or a separate entity include:
- Whether the owner or person with control uses property owned by the organization as their personal property.
- If the organization is undercapitalized: if there isn’t enough value in the organization to cover what it likely owes.
- Someone with control commits fraud or other egregious acts – This is the biggest factor.